Tuesday, December 22, 2009

Some Further Comments on Maturity Choice

In an earlier post, I discussed the issue of maturity choice for new Treasury issues, arguing that it affects not only the cost of financing the debt but also the shape of the yield curve, the extent of private sector maturity transformation, and the value of the currency (for instance if foreign lenders have different preferences over maturities relative to domestic lenders.) In many respects, therefore, the Treasury performs actions that are normally considered to be within the purview of the Federal Reserve. But while Fed policy is subject to extensive debate, as is the size of the deficit, there seems to be very little discussion of the manner in which the debt is financed by the Treasury.

Andy Harless (via Mark Thoma) has recently written a long and thoughtful post that deals with related issues. The post is worth reading in full, but here's the gist of his argument:

The inflation rate is now lower than most economists prefer, and the economy remains extremely weak despite the recent upturn in the business cycle. The burning issue is how to find the most cost-effective and politically feasible way to stimulate the US economy, and conventional monetary policy is not an option.

And today Treasury bills are not just more like money than like other assets; from a portfolio point of view, on the margin of new issuance, Treasury bills are exactly like money. Holders of short-term Treasury bills are willing to hold them without receiving interest. Anyone who is willing to hold them is placing no value whatsoever on any liquidity or safety advantage that might be had from holding those assets in the form of money.

Issuing more short-term Treasury bills will have exactly the same effect as issuing more money, since people are indifferent between the two. For practical purposes, as long as their interest rate remains at zero, short-term Treasury bills are part of the money stock. A Treasury bill is a million-dollar bill in the same sense that a Federal Reserve note with Abraham Lincoln on it is a five-dollar bill. Conventional monetary policy, which exchanges money for Treasury bills, is ineffective because it is no policy at all: it simply exchanges one form of money for another.

To put it another way, since the Treasury can issue bills that are exactly like money, it is now the Treasury that is in charge of monetary policy. And whatever one may think of the policy it chooses to follow, we should be holding the Treasury responsible. If you’re worried about “exit strategy” and the possibility of inflation in the near future, then perhaps you should congratulate the Treasury for its policy of financing more of its debt long-term. If you’re worried (as I am) about the persistence of a weak and potentially deflationary economic environment, then you should be critical of the Treasury’s policy. By increasing its maturities the Treasury is essentially following a tight-money policy exactly when a loose-money policy is needed.

The Treasury, of course, has its reasons. Officials expect interest rates to rise over the next several years and would like to lock in today’s low rates, to limit how much it will cost to service the national debt over a longer horizon. I’m skeptical, however, of the assumptions underlying these reasons.

Are interest rates going to rise over the next several years? Perhaps, but if so, then why are people being foolish enough to hold longer-term Treasury securities when they could be holding bills and waiting for a better deal? If it’s just a matter of the future course of interest rates, then it’s a zero-sum game. If the Treasury wins, bondholders lose – and bondholders usually make a point of trying not to lose. Are Treasury officials so much smarter than bondholders?

You might argue that it’s a matter of risk. When the Treasury locks in today’s low interest rates, it may not end up paying less (since it gives up even lower short-term rates), but it makes the payments more predictable. Even if the Treasury is likely to end up paying more, the hedge is worth the price, because the Treasury receives some insurance for the worst case, where rates rise more than expected.

But are rising interest rates really the worst case? Interest rates will rise when and if the economic recovery gains enough speed and traction to give the Fed and bond markets reasonable confidence in its eventual convergence toward our potential growth path. As an ordinary citizen, that’s not an outcome against which I would feel a need to hedge. I don’t want to buy insurance against good news. I’d rather hedge against the opposite outcome, where the recovery peters out and interest rates fall.

I urge you to read the whole thing. Regardless of whether or not you accept his prescriptions, the question of maturity choice deserves an airing.

Harless attributes some of his ideas to Benjamin Friedman, with whom he once studied. This reminded me of a paper that Friedman wrote with (a very young) David Laibson, published in a 1989 issue of the Brookings Papers on Economic Activity. This issue also contains an extended commentary by Hyman Minsky, whose work I have discussed previously. Both the paper and Minsky's comments on it are well worth reading, and I hope to post my thoughts on them in due course.

2 comments:

Yes, Ben Friedman has long been associated with the view that Treasury should issue more short-term debt. Before that, of course, Jim Tobin was a big proponent of Operation Twist in the 1960s. Econ grad students are generally taught that Operation Twist had little effect, but the fact is Operation Twist was never really tried. There was no measurable change in the maturity distribution of Treasury debt.

In a recent paper ( http://www.piie.com/publications/interstitial.cfm?ResearchID=1451) I cite Friedman, Tobin, and some more recent studies by Kuttner and Greenwood and Vayanos estimating the size of these effects.

I think manipulating the maturity distribution for macro stimulus at the zero bound is more naturally a monetary policy function than a fiscal function, but obviously either Fed or Treasury has the power to do it.

Joe, thank you for this comment and the references, I'll definitely take a look. Aside the question of stimulus, Treasury (and Fed) choices will affect the incidence of private sector maturity transformation. Should this be a relevant factor in evaluating these choices? I would be interested in your opinion.